Editor's note: A previous version of this story incorrectly stated that CapitalSource was formerly a business development company. The Fool regrets the error.
I admit it: I'm frugal. OK, others would call me cheap. Still, I like getting a bargain, and when things go on sale I'm willing to stock up. Whether it's soup, socks, T-shirts, or stocks, I'm loading up my cart.
Wait a minute. Stocks? Sure! While many look at the current market's malaise as a harbinger of doom and gloom, I take the view that Warren Buffett has espoused: The market is offering you a sale on your favorite company. Most people like to pay dearly for their stocks because it validates their buying decision. Me? I want 'em cheap ... as cheap as can be.
Yet it's not always necessary for a stock's price to fall for you to be able to buy it at a discount. Sometimes scenarios crop up that let you act like a hedge fund or an arbitrageur and let you root around in the bargain bin. I have to admit, though, that it was a reader of mine who passed along this tip -- otherwise, I probably would have missed it.
No doubt about it, CapitalSource took it on the chin last quarter as it wrote down $30 million against its residential investment portfolio. It also changed its status to a REIT at the beginning of 2006 to be able to deliver a higher dividend payout at a lower cost of capital. Yet since it's so new, it hasn't been stress-tested enough to see if it will be able to maintain that tax-free REIT status. The current economic environment ought to provide such proving grounds. Can it find the deals and financing its needs to remain healthy?
So far, the specialty finance company has been able to remain profitable despite the gurgling market, primarily as a result of holding the bare minimum necessary in real estate mortgages to remain REIT compliant. The balance comes from commercial loans, which are of much higher quality. So while there are indeed risks involved in CapitalSource, they seem minimal at this point, and the company looks well-positioned to capitalize on the future.
OK, so we like CapitalSource as a possible investment, and we see that its shares have been knocked for a bit of a loop recently and sit some 40% below their 52-week high. But that's not what makes them a discount -- or, rather, that's not how you can get them at discounted prices.
Last May, CapitalSource announced that it was going to acquire Nebraska savings bank TierOne
This is where you get to play George Soros.
For each share of TierOne stock that shareholders own, CapitalSource is giving them $6.80 cash plus 0.675 shares of the specialty finance company. In addition, if CapitalSource's shares are trading at less than about $25 a share, TierOne shareholders will get an additional 0.405 shares of CapitalSource stock. If CapitalSource shares are trading above the $25 threshold, TierOne shareholders will get either an additional $10.20 in cash or a fraction of CapitalSource stock that will equal that amount based on the share's closing price when the deal is consummated.
Let's say you invest $1,000 in TierOne shares. At its current price of about $19 a stub, you'd own 52 shares. When the deal closes, you'd receive $353.60 in cash plus 35 shares of CapitalSource. The finance company is currently trading around $16 a share. Let's assume that it stays at that level, meaning that as a TierOne shareholder you'd get an additional 21 CapitalSource shares, for a total of 56 shares. The total value received by you would equal about $1,250.
If you had taken that original $1,000 and bought CapitalSource shares outright, you would have ended up with 62 shares valued at $992 total. By buying TierOne shares instead, you'd have made an automatic 25% gain when the deal closes, without having to do anything else.
It gets even better if CapitalSource's stock goes up. Let's say by some miracle it appreciates by 56% and reaches the $25 threshold. You would then receive an additional $530 in cash, bringing the total value of your TierOne investment to $2,284, a 47% premium to having bought CapitalSource shares directly and held on for the price increase.
Of course, this is predicated on the deal meeting regulatory scrutiny and going through, but if you're looking for an opportunity to buy CapitalSource, I don't think you could do any better than buying TierOne shares first.
CapitalSource is a recommendation of Motley Fool Income Investor. A 30-day trial subscription is another arbitrage play you can make without risking any capital.